EMRE DELİVELİ > Braveheart ROCs Central Banking

During
a speech on Friday, Central Bank Governor Erdem Başçı underlined that it would
take a (brave) heart to implement the Bank’s latest tool, Reserve Option
Coefficients (ROCs).

Commercial
banks have been allowed to keep some of the lira reserves they are required to maintain
at the Central Bank in foreign currency (FX) for a while. At the end of
May, the Central Bank increased the upper limit of this option to 45 from
40 percent of total required reserves. It also noted that this last 5 percent
would have to be multiplied by a coefficient of 1.4. So 100 liras of reserves
could be replaced with 140 liras worth of euros or dollars.

Since
then, the Bank has not only increased the upper limit gradually to 60 percent,
it has also introduced different ROCs at different tranches. While it
cut its lending rate by 1.5 percent at the latest rate-setting meeting on
Tuesday, the Central Bank also increased all
ROCs by 0.2, which now vary between 1.3 in the first tranche of 0-40
percent to 2.2 in the final tranche of 55-60 percent and have emerged, along
with the interest rate corridor, as the primary policy tool.

You
might wonder why banks would want to keep more money as reserves that don’t pay
out any interest- the simple answer is that it is cheaper to borrow FX than
lira. In fact, you can find the threshold FX interest rate for each tranche by
dividing the cost of Central Bank funding by the ROC. Since that rate is
currently 6.1 percent, banks would want to utilize the option in full for the
first tranche as long as they can borrow in FX at lower than 4.7 (6.1/1.3)
percent.

Of
course, this is only a very rough calculation, which assumes banks can get as
much foreign funding as they want. But the more interesting question is why the
Central Bank would want to implement such a scheme. For one thing, it would
take some pressure off the lira if the country is exposed
to strong capital inflows resulting from the global
easing by the major central banks.

In
fact, ROCs can work both ways. When this hot money stops or reverses, banks
could tap their FX reserves at the Central Bank. In this sense, the Bank sees
its new tool as an automatic stabilizer. While it could indeed decrease FX
volatility, I am not sure if this novel system could withstand a major crisis. Besides,
I wonder if it is making Turkey more vulnerable by encouraging foreign
borrowing.

Başçı
noted that that having FX parked at the Central Bank makes it easier for banks
to borrow from abroad, and they have indeed resumed getting foreign loans.
That’s when I started getting confused. I thought the Bank did not want dollarization
and currency
mismatches in the first place. The ratio of short-term debt to reserves,
one of the Bank’s reserve strength indicators, is already above one.

My
confusion grew when he emphasized that only central banks not paying interest
on reserves could implement ROCs, and that required guts, or a brave heart. I
could not figure out the relationship, so I consulted a Turkey economist as
well as a couple of central bankers. They could not, either.

The
Central Bank’s new tool indeed ROCs. I hope adding another layer to the
already-complex set of policies does not make us also roll.